Financial management notes pdf

PONDICHERRY UNIVERSITY
(A Central University)
DIRECTORATE OF DISTANCE EDUCATION
MASTER OF BUSINESS ADMINISTRATION
First Year – II Semester
Paper Code: MBAC2001
FINANCIAL MANAGEMENT
(Common to all MBA Programs)

Authors
Dr. Balachandran
Professor
Alagappa University
Karaikudi.
Dr. G. Raghavan
Professor
SDM Institute of Management Development
Mysore.
Dr. G. Shanmuga Sundaram
Associate Professor
Dept. of Commerce
Pondicherry University
Puducherry.
© All Rights are Reserved

TABLE OF CONTENTS
UNIT PAGE NO.
Unit - I Finance - An Introduction 3
Unit - II Capital Budgeting - A Conceptual Framework 55
Unit - III Capital Structure Theories 116
Unit - IV Dividend Policies 156
Unit - V Working Capital Management 193

1
MBA - II Semester Paper code: MBAC2001

Financial Management
Objectives
ӹӹ To know the various sources of finance
ӹӹ To understand the various uses for finance and
ӹӹ To familiarize oneself with the techniques used in financial
management.
Unit-I
Financial Management – Financial goals - Profit vs. Wealth
Maximization; Finance Functions – Investment, Financing and Dividend
Decisions – Cost of Capital – Significance of Cost of Capital – Calculation
of Cost of Debt – Cost of Preference Capital – Cost of Equity Capital
(CAPM Model and Gordon’s Model) and Cost of Retained Earnings –
Combined Cost of Capital (weighted/Overall).
Unit-II
Capital Budgeting – Nature of Investment Decisions – Investment
Evaluation criteria – Net Present Value (NPV), Internal Rate of Return
(IRR), Profitability Index (PI), Payback Period, Accounting Rate of
Return (ARR) – NPV and IRR comparison.
Unit-III
Operating and Financial Leverage – Measurement of Leverages
– Effects of Operating and Financial Leverage on Profit – Analyzing
Alternate Financial Plans - Combined Financial and Operating Leverage
– Capital Structure Theories - Traditional approach - M.M. Hypotheses
– without Taxes and with Taxes – Net Income Approach (NI) – Net
Operating Income Approach (NOI) - Determining capital structure in
practice.

2
Unit- IV
Dividend Policies – Issues in Dividend Decisions – Relevance
Theory – Walter’s Model – Gordon’s Model – Irrelevance Theory – M-M
hypothesis - Dividend Policy in Practice – Forms of Dividends – Stability
in Dividend Policy – Corporate Dividend Behaviour.
Unit-V
Management of Working Capital – Significance and types of
Working Capital – Calculating Operating Cycle Period and Estimation
of Working Capital Requirements – Financing of Working Capital
and norms of Bank Finance – Sources of Working capital – Factoring
services– Various committee reports on Bank Finance – Dimensions of
Working Capital Management.
[Note: Distribution of Questions between Problems and Theory of this
paper must be 40:60 i.e., Problem Questions: 40 % & Theory Questions:
60 %]
REFERENCES
Khan MY, Jain PK, BASIC FINANCIAL MANAGEMENT, Tata McGraw
Hill, Delhi , 2005.
Chandra, Prasanna,. FINANCIAL MANAGEMENT, Tata McGraw Hill,
Delhi.
Bhabatosh Banerjee, FUNDAMENTALS OF FINANCIAL
MANAGEMENT, PHI, Delhi, 2010.
Chandra Bose D, FUNDAMENTALS OF FINANCIAL MANAGEMENT,
PHI, Delhi, 2010.
Preeti Singh, FUNDAMENTALS OF FINANCIAL MANAGEMENT,
Ane, 2011.

3
UNIT – I
Lesson 1 - Finance – An Introduction
Lesson Outline
ӹӹ Significance
ӹӹ Definition of Finance
ӹӹ Functions of Finance
ӹӹ Types of Finance
ӹӹ Business Finance
ӹӹ Direct Finance
ӹӹ Indirect Finance
ӹӹ Public Finance
ӹӹ Private Finance
ӹӹ Corporation Finance
ӹӹ Finance in Relation to other Allied Disciplines
Learning Objectives
After reading this lesson you should be able to
ӹӹ Understand the significance and definition of finance
ӹӹ Know the functions of finance
ӹӹ Identify the different types of finance
ӹӹ Describe this relationship between finance with other allied
disciplines

4
Significance
Finance is the life blood of business. Before discussing the nature
and scope of financial management, the meaning of ‘finance’ has to be
explained. In fact, the term, finance has to be understood clearly as it
has different meaning and interpretation in various contexts. The time
and extent of the availability of finance in any organization indicates
the health of a concern. Every organization, may it be a company, firm,
college, school, bank or university requires finance for running day to
day affairs. As every organization previews stiff competition, it requires
finance not only for survival but also for strengthening themselves.
Finance is said to be the circulatory system of the economy body, making
possible the required cooperation between the innumerable units of
activity.
Definition of Finance
According to F.W.Paish, Finance may be defined as the position of
money at the time it is wanted.
In the words of John J. Hampton, the term finance can be defined
as the management of the flows of money through an organization,
whether it will be a corporation, school, bank or government agency.
According to Howard and Upton, “finance may be defined
as that administrative area or set of administrative functions in an
organization which relates with the arrangement of each and credit so
that the organization may have the means to carry out the objectives as
satisfactorily as possible.
In the words of Bonneville and Dewey, Financing consists in the
raising, providing, managing of all the money, capital or funds of any
kind to be used in connection with the business.
As put forth by Hurband and Dockery in his book ‘Modern
Corporation Finance’, finance is defined as “an organism composed
of a myriad of separate enterprise, each working for its own ends but
simultaneously making a contribution to the system as a whole, some
force is necessary to bring about direction and co-ordination. Something
must direct the flow of economic activity and facilitate its smooth
operation. Finance is the agent that produces this result”.
The Encyclopedia Britannica defines finance as “the act of

5
providing the means of payment.” It is thus the financial aspect of
corporate planning which may be described as the management of
money.
An analysis of the aforesaid definition makes it clear that finance
directs the flow of economic activity and facilitates the smooth operation.
Finance provides the required stimulus for continued business operations
of all categories. Finance is essential for expansion, diversification,
modernization, establishment, of new projects and so on. The financial
policy of any organization to a greater extent, determines not only its
existence, and survival but also the performance and success of that
organization. Finance is required for investment, purposes as well as to
meet substantial capital expenditure projects.
Functions of Finance
According to Paul G. Hasings, “finance” is the management of
the monetary affairs of a company. It includes determining what has to
be paid for and when, raising the money on the best terms available,
and devoting the available funds to the best uses. Kenneth Midgley and
Ronald Burns state: “Financing is the process of organising the flow of
funds so that a business can carry out its objectives in the most efficient
manner and meet its obligations as they fall due.”
Finance squeezes the most out of every available rupee. To get
the best out of the available funds is the major task of finance, and
the finance manager performs this task most effectively if he is to be
successful. In the words of Mr.A.L.Kingshott, “Finance is the common
denominator for a vast range of corporate objectives, and the major part
of any corporate plan must be expressed in financial terms.”
The description of finance may be applied to money management
provided that the following three objectives are properly noted:
Many activities associated with finance such as saving, payment
of things, giving or getting credit; do not necessarily require the use of
money.
In the first place, the conduct of international trade has been
facilitated. The development of the pecuniary unit in the various
commercial nations has given rise to an international denominator of
values. The pecuniary unit makes possible a fairly accurate directing
of capital to those parts of the world where it will be most productive.

6
Within any given country, the flow of capital from one region to another
is guided in a similar manner.
The term ‘finance’ refers to the financial system in a rudimentary
or traditional economy, that is, an economy in which the per capita output
is low and declining over a period of time. The financial organisation
in rudimentary finance is characterized by the absence of any financial
instruments of the saving deficit units of their own which they can issue
and attract savings. There will not be any inducement for higher savings
by offering different kinds of financial assets to suit the varied interests
and preferences of the investing public. The other characteristic of such
a financial system is that there are no markets where firms can compete
for private savings.
Types of Finance
Business Finance
The term ‘business finance’ is very comprehensive. It implies
finances of business activities. The term, ‘business’ can be categorized into
three groups: commerce, industry and service. It is a process of raising,
providing and managing of all the money to be used in connection with
business activities.
It encompasses finance of sole proprietary organizations,
partnership firms and corporate organizations. No doubt, the aforesaid
organizations have different characteristics, features, distinct regulations
and rules. And financial problems faced by them vary depending upon
the nature of business and scale of operations. However, it should be
remembered that the same principles of finance are applicable to large
and small organizations, proprietary and non-proprietary organizations.
According to Guthmann & Dougall, business finance can be
broadly defined as the activity concerned with planning, raising,
controlling and administering of funds used in the business.
Business finance deals with a broad spectrum of the financial
activities of a business firm. It refers to the raising and procurement
of funds and their appropriate utilisation. It includes within its scope
commercial finance, industrial finance, proprietary finance corporation
finance and even agricultural finance.
The subject of business finance is much wider than that of

7
corporation finance. However, since corporation finance forms the lion’s
share in the business activity, it is considered almost inter-changeable with
business finance. Business finance, apart from the financial environment
and strategies of financial planning, covers detailed problems of company
promotion, growth and pattern. These problems of the corporate sector
go a long way in widening the horizon of business finance.
The finance manager has to assume the new responsibility of
managing the total funds committed to total assets and allocating funds
to individual assets in consonance with the overall objectives of the
business enterprise.
Direct Finance
The term ‘direct’, as applied to the financial organisation, signifies
that savings are affected directly from the saving-surplus units without
the intervention of financial institutions such as investment companies,
insurance companies, unit trusts, and so on.
Indirect Finance
The term ‘indirect finance’ refers to the flow of savings from the
savers to the entrepreneurs through intermediary financial institutions
such as investment companies, unit trusts and insurance companies, and
so on.
Finance administers economic activities. The scope of finance is
vast and determined by the financial needs of the business enterprise,
which have to be identified before any corporate plan is formulated. This
eventually means that financial data must be obtained and scrutinised.
The main purpose behind such scrutiny is to determine how to maintain
financial stability.
Public Finance
It is the study of principles and practices pertaining to acquisition
of funds for meeting the requirements of government bodies and
administration of these funds by the government.
Private Finance
It is concerned with procuring money for private organization
and management of the money by individuals, voluntary associations
and corporations. It seeks to analyse the principles and practices of

8
managing one’s own daily affairs. The finance of non-profit organization
deals with the practices, procedures and problems involved in the
financial management of educational chartable and religions and the like
organizations.
Corporation Finance
Corporation finance deals with the financial problems of a
corporate enterprise. These problems include the financial aspects of
the promotion of new enterprises and their administration during their
early period ; the accounting problems connected with the distinction
between capital and income, the administrative problems arising out of
growth and expansion, and, finally, the financial’ adjustments which are
necessary to bolster up to rehabilitate a corporation which has run into
financial difficulties.
The term ‘corporation finance’ includes, apart from the financial
environment, the different strategies of financial planning. It includes
problems of public deposits, inter-company loans and investments,
organised markets such as the stock exchange, the capital market, the
money market and the bill market. Corporation finance also covers
capital formation and foreign capital and collaborations.
Finance in Relation to Other Allied Disciplines
The finance function cannot work effectively unless it draws
on the-disciplines which are closely associated with it. Management is
heavily dependent on accounting for operating facts. Accounting’ has
been described by Richard M. Lynch and Robert W. Williamson as “the
- measurement and communication of financial and economical data. In
fact, accounting information relates to the production, sales, expenses,
investments, losses and gains of the business. Accounting has three
branches namely, financial accounting, cost accounting and management
accounting.

9
Relationships between Finance and other Disciplines
Supports
Primary Disciplines
1. Accounting
2. Economics
3. Taxation
Other Disciplines
1. Operations
Research
2. Production
Finance Decisions
Investment, Working
capital, Leverage
Dividend policy
Supports
Financial Accounting
It is concerned with the preparation of reports which provide
information to users outside the firm. The most common reports are
the financial statements included in the annual reports of stock-holders
and potential investors. The main objective of these-reports is to inform
stockholders, creditors and other investors how assets are controlled
by a firm. In the light of the financial statements and certain other
information, the accountant prepares funds film statement, cash flow
statement and budgets.
A master plan (Budget) of the organization includes and
coordinates the plans of every department in financial terms. According
to Guthmann and Dougall, “Problems of finance are intimately connected
while problems of purchasing, production and marketing”.
Cost Accounting
It deals primarily with cost data. It is the process of classifying,
recording, allocating and reporting the various costs incurred in the
operation of an enterprise. It includes a detailed system of control for
material, labour and overheads. Budgetary control and standard casting
are integral part of cost accounting. The purpose of cost accounting is to
provide information to the management for decision making, planning
and control. It facilitates cost reduction and cost control. It involves
reporting of cost data to the management.

10
Management Accounting
It refers to accounting for the management. It provides necessary
information to assist the management in the creation of policy and
in the day to day operations. It enables the management to discharge
all its functions, namely, planning, organizing, staffing, direction and
control efficiently with the help of accounting information. Functions of
management accounting include all activities connected with collecting,
processing, interpreting and presenting information to the management.
According to J. Batty, ‘management accounting’ is the term used to
describe the accounting methods, systems and technique which coupled
with special knowledge and ability, assist management in its task of
maximizing profits or minimizing losses. Management accounting is
related to the establishment of cost centres, preparation of budgets,
and preparation of cost control accounts and fixing of responsibility for
different functions.
Summary
Finance is the life blood of business. Before discussing the nature
and scope of financial management, the meaning of ‘finance’ has to be
explained. In fact, the term, finance has to be understood clearly as it
has different meaning and interpretation in various contexts. The time
and extent of the availability of finance in any organization indicates the
health of a concern. Finance may be defined as the position of money
at the time it is wanted. Financing consists in the raising, providing,
managing of all the money, capital or funds of any kind to be used in
connection with the business.
The term ‘business finance’ is very comprehensive. It implies
finances of business activities. The term, ‘business’ can be categorized into
three groups: commerce, industry and service. It is a process of raising,
providing and managing of all the money to be used in connection with
business activities. The term ‘corporation finance’ includes, apart from
the financial environment, the different strategies of financial planning.
It includes problems of public deposits, inter-company loans and
investments, organised markets such as the stock exchange, the capital
market, the money market and the bill market.
The finance function cannot work effectively unless it draws
on the-disciplines which are closely associated with it. Management is

11
heavily dependent on Accounting, Economics, Taxation, Operations
research, Production and Marketing.
Keywords
Finance
It is defined as the position of money at the time it is wanted.
Business Finance
According to Guthmann & Dougall, business finance can be
broadly defined as the activity concerned with planning, raising,
controlling and administering of funds used in the business.
Corporation Finance
The term ‘corporation finance’ includes, apart from the financial
environment, the different strategies of financial planning. It includes
problems of public deposits, inter-company loans and investments,
organised markets such as the stock exchange, the capital market, the
money market and the bill market.
Accounting
It relates to the production, sales, expenses, investments, losses
and gains of the business.
Financial Accounting
The most common reports are the financial statements included
in the annual reports of stock-holders and potential investors.
Cost Accounting
It deals primarily with cost data. It is the process of classifying,
recording, allocating and reporting the various costs incurred in the
operation of an enterprise. It includes a detailed system of control for
material, labour and overheads.
Management Accounting
It refers to accounting for the management. It provides necessary
information to assist the management in the creation of policy and in
the day to day operations. It enables the management to discharge all its
functions, namely, planning, organizing, staffing, direction and control

12
efficiently with the help of accounting information.
Management
Process of attainment of predetermined goals by directing
activities of a group of persons and employing other resources.
Review Questions
1. Explain fully the concept of finance.
2. Bring out the importance of finance.
3. It is often said that financial activities hinge on the money
management. Do you agree with this point of view?
4. “Financial accounting is essentially of a stewardship nature”
Comment.
5. What is business finance? Explain its significance.
6. How can you classify finance?
7. How is finance related to other disciplines?
****

13
Lesson 2 - Finance Function
Lesson Outline
ӹӹ Nature of Finance Function
ӹӹ Content of Finance Function
ӹӹ Finance Function - Objectives
ӹӹ Changing Concept of Finance
ӹӹ Scope of Finance Function
ӹӹ Organisation of the Finance Function
ӹӹ Meaning of the Finance Function
ӹӹ Finance Function - A New Perspective
Learning Objectives
After reading this lesson, you should be able to
ӹӹ Understand the nature of finance function
ӹӹ Analyse the content of finance function
ӹӹ Know the objectives of finance function
ӹӹ Understand the changing concept of finance.
ӹӹ Discuss the scope of the finance function
ӹӹ Describe the organization of finance function
ӹӹ Know the meaning of controller and treasure
ӹӹ Understand the new perspective of finance function
Nature of Finance Function
The finance function is the process of acquiring and utilizing
funds of a business. Finance functions are related to overall management
of an organization. Finance function is concerned with the policy
decisions such as like of business, size of firm, type of equipment used,
use of debt, liquidity position. These policy decisions determine the
size of the profitability and riskiness of the business of the firm. Prof.
K.M.Upadhyay has outlined the nature of finance function as follows:

14
i) In most of the organizations, financial operations are centralized.
This results in economies.
ii) Finance functions are performed in all business firms, irrespective
of their sizes / legal forms of organization.
iii) They contribute to the survival and growth of the firm.
iv) Finance function is primarily involved with the data analysis for
use in decision making.
v) Finance functions are concerned with the basic business activities
of a firm, in addition to external environmental factors which affect
basic business activities, namely, production and marketing.
vi) Finance functions comprise control functions also
vii) The central focus of finance function is valuation of the firm.
Content of Finance Functions
The areas of responsibility covered by finance functions may be
regarded as the content of finance function. These areas are specific
functions of finance. Famous authors of financial management have
enumerated the contents of finance function, as outlined, below:
Name of the Author Content of Finance Functions
1) James C. Van Horne
Investment Decision
Financing Decision
Dividend Decisions
2) Earnest W. Walker
Financial Planning
Financial Co-ordination
Financial Control
3) J. Fred Weston and
Eugene F. Brigham
Financial Planning and Control
Management of Working Capital
Investment in Fixed Assets
Capital Structure Decisions
Individual Financing Episodes

15
It is clear from the above, that, finance functions can be grouped
as outlined below:
i) Financial planning
ii) Financial control
iii) Financing decisions
iv) Investment decision
v) Management of income and dividend decision
vi) Incidental functions
Finance Function – Objectives
The objective of finance function is to arrange as much funds for
the business as are required from time to time. This function has the
following objectives.
1. Assessing the Financial Requirements
The main objective of finance function is to assess the financial
needs of an organization and then finding out suitable sources for
raising them. The sources should be commensurate with the needs of the
business. If funds are needed for longer periods then long-term sources
like share capital, debentures, term loans may be explored.
2. Proper Utilisation of Funds
Though raising of funds is important but their effective utilisation
is more important. The funds should be used in such a way that maximum
benefit is derived from them. The returns from their use should be more
than their cost. It should be ensured that funds do not remain idle at
any point of time. The funds committed to various operations should
be effectively utilised. Those projects should be preferred which are
beneficial to the business.
3. Increasing Profitability
The planning and control of finance function aims at increasing
profitability of the concern. It is true that money generates money. To
increase profitability, sufficient funds will have to be invested. Finance
function should be so planned that the concern neither suffers from
inadequacy of funds nor wastes more funds than required. A proper

16
control should also be exercised so that scarce resources are not frittered
away on uneconomical operations. The cost of acquiring funds also
influences profitability of the business.
4. Maximising Value of Firm
Finance function also aims at maximizing the value of the firm. It
is generally said that a concern’s value is linked with its profitability.
The Changing Concept of Finance
According to Ezra Solomon, the changing concept of finance can
be analysed by dividing the entire process into three broad groupings.
First Approach
This approach just emphasizes only on the liquidity and financing
of the enterprise.
Traditional Approach
This approach is concerned with raising of funds used in an
organization. It compasses
a) instruments, institutions and practice through which funds are
augmented.
b) the legal and accounting relationship between a company and its
source of funds.
Modern Approach
This approach is concerned not only with the raising of funds, but
their administration also. This approach encompasses
a) Determination of the sum total amount of funds to employ in the
firm.
b) Allocation of resources efficiently to various assets.
c) Procuring the best mix of financing – i.e. the type and amount of
corporate securities.
An analysis of the aforesaid approaches unfold that modern
approach involving an integrated approach to finance has considered
not only determination of total amount of funds but also allocation of
resources efficiently to various assets of the firm. Thus one can easily
make out that the concept of finance has undergone a perceptible change.

17
This is evident from the views expressed by one of the financial
experts, namely, James C Van Horne and the same are reproduced below:
Finance concept (function or scope) has changed from a primarily
descriptive study to one that encompasses regions analysis and normative
theory; from a field that was concerned primarily with the procurement
of funds to one that includes the management of assets, the allocation
of capital and the valuation of the firm as a whole; and from a field that
emphasized external analysis to the firm to one that stresses decision
making within the firm. Finance, today, is best characterized as ever
changing with new ideas and techniques. The role of financial manager
is considerably different from what it was a few years ago and from what
it will no doubt be in another coming years. Academicians and financial
mangers must grow to accept the changing environment and master its
challenge.
Scope of Finance Function
The scope of finance function is very wide. While accounting is
concerned with the routine type of work, finance function is concerned
with financial planning, policy formulation and control. Earnest W.
Walker and William are of the opinion that the financial function
has always been important in business management. The financial
organiastion depends upon the nature of the organization – whether
it is a proprietary organsation, a partnership firm or corporate body.
The significance of the finance function depends on the nature and size
of a business firm. The role of various finance officers must be clearly
defined to avoid conflicts and the overlapping of responsibilities. The
operational functions of finance include:
1. Financial planning
2. Deciding the capital structure
3. Selection of source of finance
4. Selection of pattern of investment
Financial Planning
The first task of a financial manager is to estimate short-term
and long-term financial requirements of his business. For this purpose,
he will prepare a financial plan for present as well as for future. The
estimation of fund is essential to purchase fixed assets as well as for the
rotation of working capital. The estimations should be based on sound

18
financial principles so that neither there are inadequate nor excess funds
with the concern. The inadequacy of funds will adversely affect the day-
to-day operations of the concern whereas excess funds may tempt a
management to indulge in extravagant spending or speculative activities.
Deciding Capital Structure
The Capital structure refers to the kind and proportion of different
securities for raising funds. After deciding about the quantum of funds
required it should be decided which type of securities should be raised.
It may be wise to finance fixed assets through long-term debts. Even
if gestation period is longer, then share capital may be most suitable.
Long-term funds should be raised. It may be wise to finance fixed assets
through long-term debts. Even here if gestation period is longer, then
share capital may be most suitable. Long-term funds should be employed
to finance working capital also, if not wholly then partially. Entirely
depending upon overdrafts and cash creditors for meeting working
capital needs may not be suitable. A decision about various sources for
funds should be linked to the cost of raising funds. If cost of raising
funds is very high then such sources may not be useful for long.
Selection of Source of Finance
After preparing a capital structure, an appropriate source of
finance is selected. Various sources, from which finance may be raised,
include share capital, debentures, financial institutions, commercial
banks, public deposits, etc. If finances are needed for short periods then
banks, public deposits and financial institutions may be appropriate;
on the other hand, if long-term finances are required then share capital
and debentures may be useful. If the concern does not want to tie down
assets as securities then public deposits may be a suitable source. If
management does not want to dilute ownership then debentures should
be issued in preference to share.
Selection of Pattern of Investment
When funds have been procured then a decision about investment
pattern is to be taken. The selection of an investment pattern is related to
the use of funds. A decision will have to be taken as to which assets are
to be purchased? The funds will have to be spent first on fixed assets and
then an appropriate portion will be retained for Working Capital. The
decision-making techniques such as Capital Budgeting, Opportunity

19
Cost Analysis, etc. may be applied in making decisions about capital
expenditures. While spending on various assets, the principles of safety,
profitability and liquidity should not he ignored. A balance should be
struck even in these principles.
Organization of the Finance Functions
Today, finance function has obtained the status of a science
and an art. As finance function has far reaching significance in overall
management process, structural organization for further function
becomes an outcome of an important organization problem. The
ultimate responsibility of carrying out the finance function lies with
the top management. However, organization of finance function differs
from company to company depending on their respective requirements.
In many organizations one can note different layers among the finance
executives such as Assistant Manager (Finance), Deputy Manager
(Finance) and General Manager (Finance). The designations given to the
executives are different. They are
Chief Finance Officer (CFO)
Vice-President (Finance)
Financial Controller
General Manager (Finance)
Finance Officers
Finance, being an important portfolio, the finance functions is
entrusted to top management. The Board of Directors, who are at the
helm of affairs, normally constitutes a ‘Finance Committee’ to review
and formulate financial policies. Two more officers, namely ‘treasurer’
and ‘controller’ – may be appointed under the direct supervision of CFO
to assist him/her. In larger companies with modern management, there
may be Vice-President or Director of finance, usually with both controller
and treasurer. The organization of finance function is portrayed below:

20
Organization of Finance Function
Board of Directors
Managing Directors
Production
Director
Purchase
Director
Finance
Director
Personnel
Director
Marketing
Director
Treasurer Controller
Auditing Credit Analysis Planning &
Budgeting
Cost and
inventory
Pension
management
Cost
management
Profit Analysis Accounting
and pay roll
It is evident from the above that Board of Directors is the
supreme body under whose supervision and control Managing Director,
Production Director, Personnel Director, Financial Director, Marketing
Director perform their respective duties and functions. Further while
auditing credit management, retirement benefits and cost control
banking, insurance, investment function under treasurer, planning and
budgeting, inventory management, tax administration, performance
evaluation and accounting functions are under the supervision of
controller.
Meaning of Controller and Treasurer
The terms ‘controller’ and ‘treasurer’ are in fact used in USA.
This pattern is not popular in Indian corporate sector. Practically, the
controller / financial controller in India carried out the functions of
a Chief Accountant or Finance Officer of an organization. Financial
controller who has been a person of executive rank does not control
the finance, but monitors whether funds so augmented are properly
utilized. The function of the treasurer of an organization is to raise funds
and manage funds. The treasures functions include forecasting the

21
financial requirements, administering the flow of cash, managing credit,
flotation of securities, maintaining relations with financial institutions
and protecting funds and securities. The controller’s functions include
providing information to formulate accounting and costing policies,
preparation of financial reports, direction of internal auditing, budgeting,
inventory control payment of taxes, etc. According to Prof. I.M. Pandey,
while the controller’s functions concentrate the asset side of the balance
sheet, the treasurer’s functions relate to the liability side.
Finance Function – A Fresh look
The designation Finance Manager or Director (Finance) is very
popular in Indian Corporate sector. The key function of any financial
manager in India is management of funds. It means given the constraints,
he must ensure optimum utilization of funds. The financial managers
have significant involvement in injecting financial discipline in
corporate management processes. They are responsible for emphasizing
the need for rational use of funds and the necessity for monitoring the
operations of the firm to achieve expected results. The finance functions
of augmenting resources and utilisation of funds, no doubt, have a
significant impact on other functions also. In fact, between finance on
one side and production, marketing and other functions on the other
side, an inseparable relationship exists. The Board of Directors have
been bestowed with the onerous responsibility of reviewing financial
procedures, formulation of financial policies, selection of right finance
personnel with professional capabilities like Chartered Accountant,
Cost Accountant and Company Secretaries. The Board of Directors with
counsel and direction given by the financial manager finalise decisions
pertaining to formulation of new projects, diversification of projects,
expansion of undertaking, introduction of new products, widening
the branch areas, diversification of new product lines. It should be
remembered that the financial controller, in fact, does not control
finance. For management control and planning, the financial controller
develops uses and interprets information.
Summary
funds of a business. Finance functions are related to overall management
of an organization. Finance function is concerned with the policy
decisions such as like of business, size of firm, type of equipment used,

22
use of debt, liquidity position. These policy decisions determine the size
of the profitability and riskiness of the business of the firm. The areas
of responsibility covered by finance functions may be regarded as the
content of finance function. These areas are specific functions of finance.
The main objective of finance function is to assess the financial needs of
an organization and then finding out suitable sources for raising them.
The funds should be used in such a way that maximum benefit
is derived from them. Finance function also aims at maximizing the
value of the firm. It is generally said that a concern’s value is linked with
its profitability. Finance, today, is best characterized as ever changing
with new ideas and techniques. The role of financial manager is
considerably different from what it was a few years ago and from what
it will no doubt be in another coming years. Academicians and financial
mangers must grow to accept the changing environment and master its
challenge. Finance, being an important portfolio, the finance function
is entrusted to top management. The Board of Directors, who are at the
helm of affairs, normally constitutes a ‘Finance Committee’ to review
and formulate financial policies. Two more officers, namely ‘treasurer’
and ‘controller’ – may be appointed under the direct supervision of CFO
to assist him/her. The Board of Directors have been bestowed with the
onerous responsibility of reviewing financial procedures, formulation of
financial policies, selection of right finance personnel with professional
capabilities like Chartered Accountant, Cost Accountant and Company
Secretaries. The Board of Directors with counsel and direction given
by the financial manager finalise decisions pertaining to formulation
of new projects, diversification of projects, expansion of undertaking,
introduction of new products, widening the branch areas, diversification
of new product lines.
Keywords
Finance Function:
funds of a business.
Content of finance function:
The areas of responsibility covered by finance functions may be
regarded as the content of finance function.

23
Controller:
He is concerned with the management and control of firm’s
assets.
Treasurer:
He is concerned with managing the firm’s funds and safeguarding
assets.
Review Questions
1) What is finance function?
2) State the objectives of finance function.
3) Explain the significance of finance function.
4) Analyse the various approaches to finance function.
5) Explain the role of CFO in financial management.
6) Discuss the support extended by the Board of Directors in
managing finance.
7) Explain the scope of finance function.
8) Elucidate the changing facet of finance function.
****

24
Lesson 3 - Financial Management – Nature And Scope
Lesson Outline
ӹӹ Financial Management - Significance
ӹӹ Financial Management - Definition
ӹӹ Evaluation of Financial Management
ӹӹ Nature of Financial Management
ӹӹ Financial Management Key Areas
ӹӹ Financial Manager Functions
ӹӹ Financial Management as Science or Art
Learning Objectives
ӹӹ Understand the significance of financial management
ӹӹ Know the definition of financial management
ӹӹ Details the evaluation of Financial management
ӹӹ Analyse the nature of financial management
ӹӹ Identify the key areas of financial management
ӹӹ Enumerate the functions of financial manager
ӹӹ Understand how financial management is considered both an art
and science
Financial Management – Significance
Financial management has undergone fundamental changes as
regards its scope and coverage. Financial management is the application
of planning and control to the finance function. It helps in profit planning,
measuring costs, controlling inventories, and accounts receivables.
It also helps in monitoring the effective deployment of funds in fixed
assets and in working capital. It aims at ensuring that adequate cash is on

25
hand to meet the required current and capital expenditure. It facilitates
ensuring that significant capital is procured at the minimum cost to
maintain adequate cash on hand to meet any exigencies that may arise
in the course of business. Financial management helps in ascertaining
and managing not only current requirements but also future needs of an
organization.
ӹӹ It ensures that funds are available at the right time and procurement
of funds does not interfere with the right of management / exercising
control over the affairs of the company.
ӹӹ It influences the profitability / return on investment of a firm.
ӹӹ It influences cost of capital. Efficient fund managers endeavour to
locate less cost source so as to enhance profitability of organization.
ӹӹ It affects the liquidity position of firms.
ӹӹ It enhances market value of the firm through efficient and effective
financial management.
ӹӹ Financial management is very much required for the survival,
growth, expansion and diversification of business.
ӹӹ It is required to ensure purposeful resource allocation.
Financial Management – Definition
According to Weston and Brigham, financial management is an
area of financial decision making, harmonizing individual motives and
enterprise goals.
In the words of Phillippatus, financial management is concerned
with the managerial decisions that result in the acquisition and financing
of long-term and short-term credits for the firm. As such it deals with
the situations that require selection of specific assets / combination of
assets, the selection of specific liability / combination of liabilities as well
as the problem of size and growth of an enterprise. The analysis of these
decisions is based on the expected inflows and outflows of funds and
their effects upon managerial objectives.
Evolution of Financial Management
Finance, as capital, was part of the economics discipline for a long
time. So, financial management until the beginning of the 20th century
was not considered as a separate entity and was very much a part of
economics.

26

In the 1920s, liquidity management and raising of capital assumed
importance. The book, `FINANCIAL POLICY OF CORPORATIONS’
written by Arthur Stone Dewing in 1920 was a scholarly text on financing
and liquidity management, i.e., cash management and raising of capital
in 1920s.
In the 1930s there was the Great Depression, i.e., all round price
declines, business failures and declining business. This forced the business
to be extremely concerned with solvency, survival, reorganisation and so
on. Financial Management emphasized on solvency management and on
debt-equity proportions besides that the external control on businesses
became more pronounced.
Till early 1950s financial management was concerned with
maintaining the financial chastity of the business. Conservatism,
investor/lendor related protective covenants/information processing,
issue management, etc. were the prime concerns. It was an outsider-
looking-in function.
From the middle of 1950s financial management turned into an
insider-looking-in function. That is, the emphasis shifted to utilisation of
funds from funds. So, choice of investment, capital investment appraisals,
etc., is assumed importance. Objective criteria for commitment of funds
in individual assets were evolved.
Towards the close of the 1950s Modigliani and Miller even argued
that sources of capital were irrelevant and only the investment decisions
were relevant. Such was the total turn in the emphasis of financial
management.
In the 1960s portfolio management of assets gained importance.
In the selection of investment opportunities portfolio approach was
adopted, certain combinations of assets give more overall return given
the risk or give a certain return for a reduced risk. So, selection of such
combination of investments gained eminence.
In the 1970s the capital asset pricing model (CAPM), arbitrage
pricing model (APM), option pricing model (OPM), etc., were developed
- all concerned with how to choose financial assets. In the 1980s further
advances in financial management were found. Conjunction of personal
taxation with corporate taxation, financial signaling, efficient market

27
hypothesis, etc., was some newer dimensions of corporate financial
decision paradigm. Further Merger and Acquisition (M&A) became an
important corporate strategy.

The 1960’s saw the era of financial globalization. Educational
globalization is the order of the day. Capital moved west to east, north
to South and so on. So, global financial management, global investment
management, foreign exchange risk management, etc., become more
important topics.

In late 1990s and 2000s, corporate governance got preeminence
and financial disclosure and related norms are being great concerns of
financial management. The dawn of 21st
Century is heralding a new era
of financial management with cyber support. The developments till mid
1950s are branded as classical financial management. This dealt with
cash management, cash flow management, raising capital, debt-equity
norms, issue management, solvency management and the like. The
developments since mid - 1950s and upto 1980s, are branded as modern
financial management. The emphasis is on asset management, portfolio
approach, capital asset pricing model, financial signaling, and efficient
market hypothesis and so on. The developments since the 1990s may be
called post modern financial management with great degree of global
financial integration net supported finances and so on.
Nature of Financial Management
Financial management is applicable to every type of organization,
irrespective of the size, kind or nature. Every organization aims to utilize
its resources in a best possible and profitable way.
i) Financial Management is an integral part of overall
management. Financial considerations are involved in all
business decisions. Acquisition, maintenance, removal or
replacement of assets, employee compensation, sources and
costs of different capital, production, marketing, finance and
personnel decision, almost all decisions for that matter have
financial implications. Therefore, financial management is
pervasive throughout the organisation.
ii) The central focus of financial management is valuation of

28
the firm. Financial decisions are directed at increasing/
maximization/ optimizing the value of the institution. Weston
and Brigham depict the above orientation in the exhibit given
below:
Orientation of Financial Management
Policy Decisions
1. Line of activities
2. Mode of entry
3. Size of operation
4. Assets mix
5. Capital mix
6. Liquidity
7. Solvency
Risk
Return
Value of Institute
iii) Financial management essentially involves risk-return trade-
off. Decisions on investment involve choosing of types of
assets which generate returns accompanied by risks. Generally
higher the risk returns might be higher and vice versa. So, the
financial manager has to decide the level of risk the firm can
assume and satisfy with the accompanying return. Similarly,
cheaper sources of capital have other disadvantages. So to avail
the benefit of the low cost funds, the firm has to put up with
certain risks, so, risk-return trade-off is there throughout.
iv) Financial management affects the survival, growth and
vitality of the institution. Finance is said to be the life blood of
institutions. The amount, type, sources, conditions and cost of
finance squarely influence the functioning of the institution.
v) Finance functions, i.e., investment, raising of capital,
distribution of profit, are performed in all firms - business
or non-business, big or small, proprietary or corporate
undertakings. Yes, financial management is a concern of every
concern including educational institutions.

29
vi) Financial management is a sub-system of the institutional
system which has other subsystems like academic activities,
research wing, etc, In systems arrangement financial sub-
system is to be well-coordinated with others and other sub-
systems well matched with the financial sub-system.
vii) Financial management of an institution is influenced by
the external legal and economic environment. The legal
constraints on using a particular type of funds or on investing
in a particular type of activity, etc., affect financial decisions
of the institution. Financial management is, therefore, highly
influenced/constrained by external environment.
viii) Financial management is related to other disciplines like
accounting, economics, taxation, operations research,
mathematics, statistics etc., It draws heavily from these
disciplines.
ix) There are some procedural finance functions - like
record keeping, credit appraisal and collection, inventory
replenishment and issue, etc. It is normally delegated to
bottom level management executives.
x) The nature of finance function is influenced by the special
characteristic of the business. In a predominantly technology
oriented institutions like CSIR, CECRI, it is the R & D
functions which get more dominance, while in a university or
college the different courses offered and research which get
more priority and so on.
Financial Management – Key Areas
The key areas of financial management are discussed in the
following paragraphs:
1. Estimating the Capital Requirements of the Concern
The Financial Manager should exercise maximum care in
estimating the financial requirement of the firm. To do this most
effectively, he will have to use long-range planning techniques. This is
because, every business enterprise requires funds not only for long-term
purposes for investment in fixed assets, but also for short term so as to have

30
sufficient working capital. He can do his job properly if he can prepare
budgets of various activities for estimating the financial requirements
of the enterprise. Carelessness in this regard is sure to result in either
deficiency or surplus of funds. If the concern is suffering because of
insufficient capital, it cannot successfully meet its commitments in time,
whereas if it has acquired excess capital, the task of managing such excess
capital may not only prove very costly but also tempt the management to
spend extravagantly.
2. Determining the Capital Structure of the Enterprise
The Capital Structure of an enterprise refers to the kind and
proportion of different securities. The Financial Manager can decide
the kind and proportion of various sources of capital only after the
requirement of Capital Funds has been decided. The decisions regarding
an ideal mix of equity and debt as well as short-term and long-term
debt ratio will have to be taken in the light of the cost of raising finance
from various sources, the period for which the funds are required and
so on. Care should be taken to raise sufficient long-term capital in order
to finance the fixed assets as well as the extension programme of the
enterprise in such a wise manner as to strike an ideal balance between
the own funds and the loan funds of the enterprise.
3. Finalising the Choice as to the Sources of Finance
The capital structure finalised by the management decides the
final choice between the various sources of finance. The important
sources are share-holders, debenture-holders, banks and other financial
institutions, public deposits and so on. The final choice actually depends
upon a careful evaluation of the costs and other conditions involved in
these sources. For instance, although public deposits carry higher rate of
interest than on debentures, certain enterprises prefer them to debentures
as they do not involve the creation of any charge on any of the company’s
assets. Likewise, companies that are not willing to dilute ownership may
prefer other sources instead of investors in its share capital.
4. Deciding the Pattern of Investment of Funds
The Financial Manager must prudently invest the funds procured,
in various assets in such a judicious manner as to optimise the return on
investment without jeopardising the long-term survival of the enterprise.
Two important techniques— (i) Capital Budgeting; and (ii) Opportunity

31
Cost Analysis—can guide him in finalising the investment of long-
term funds by helping him in making a careful assessment of various
alternatives. A portion of the long-term funds of the enterprise should
be earmarked for investment in the company’s working capital also.
He can take proper decisions regarding the investment of funds only
when he succeeds in striking an ideal balance between the conflicting
principles of safety, profitability and liquidity. He should not attach all
the importance only to the canon of profitability. This is particularly
because of the fact that the company’s solvency will be in jeopardy, in
case major portion of its funds are locked up in highly profitable but
totally unsafe projects. .
5. Distribution of Surplus Judiciously
The Financial Manager should decide the extent of the surplus
that is to be retained for ploughing back and the extent of the surplus
to be distributed as dividend to shareholders. Since decisions pertaining
to disposal of surplus constitute a very important area of Financial
Management, he must carefully evaluate such influencing factors as—
(a) the trend of earnings of the company; (A) the trend of the market
price of its shares; (c) the extent of funds required for meeting the self-
financing needs of the company; (d) the future prospects; (e) the cash
flow position, etc.
6. Efficient Management of Cash
Cash is absolutely necessary for maintaining enough liquidity.
The Company requires cash to—(a) pay off creditors; (b) buy stock of
materials; (c) make payments to laborers; and (d) meet routine expenses.
It is the responsibility of the Financial Manager to make the necessary
arrangements to ensure that all the departments of the Enterprise get
the required amount of cash in time for promoting a smooth flow of
all operations. Short-age of cash on any particular occasion is sure to
damage the credit- worthiness of the enterprise. At the same time, it is
not advisable to keep idle cash also. Idle cash should be invested in near-
cash assets that are capable of being converted into cash quickly without
any loss during emergencies. The exact requirements of cash during
various periods can be assessed by the Financial Manager by preparing a
cash-flow statement in advance.

32
Finance Manager – Functions
Finance manager is an integral part of corporate management of
an organization. With his profession experience, expertise knowledge
and competence, he has to play a key role in optimal utilization of
financial resources of the organization. With the growth in the size of the
organization, degree of specialization of finance function increases. In
large undertakings, the finance manager is a top management executive
who participants in various decision making functions. He has to
update his knowledge with regard to Foreign Direct Investment (FDI),
Foreign portfolio investment, mergers, amalgamations acquisitions, and
corporate restructuring, performance management, risk management
corporate governance, investor relations, working capital management,
derivative trading practices, investor education and investor protection
etc.
1. Forecasting of Cash Flow. This is necessary for the successful day to
day operations of the business so that it can discharge its obligations
as and when they rise. In fact, it involves matching of cash inflows
against outflows and the manager must forecast the sources and
timing of inflows from customers and use them to pay the liability.
2. Raising Funds: the Financial Manager has to plan for mobilising
funds from different sources so that the requisite amount of funds
are made available to the business enterprise to meet its requirements
for short term, medium term and long term.
3. Managing the Flow of Internal Funds: Here the Manager has to keep
a track of the surplus in various bank accounts of the organisation
and ensure that they are properly utilised to meet the requirements of
the business. This will ensure that liquidity position of the company is
maintained intact with the minimum amount of external borrowings.
4. To Facilitate Cost Control: The Financial Manager is generally
the first person to recognise when the costs for the supplies or
production processes are exceeding the standard costs/budgeted
figures. Consequently, he can make recommendations to the top
management for controlling the costs.
5. To Facilitate Pricing of Product, Product Lines and Services: The
Financial Manager can supply important information about cost
changes and cost at varying levels of production and the profit

33
margins needed to carry on the business successfully. In fact, financial
manager provides tools of analysis of information in pricing decisions
and contribute to the formulation of pricing policies jointly with the
marketing manager.
6. Forecasting Profits: The Financial manager is usually responsible for
collecting the relevant data to make forecasts of profit levels in future.
7. Measuring Required Return: The acceptance or rejection of an
investment proposal depends on whether the expected return from
the proposed investment is equal to or more than the required return.
An investment project is accepted if the expected return is equal or
more than the required return. Determination of required rate of
return is the responsibility of the financial manager and is a part of
the financing decision.
8. Managing Assets: The function of asset management focuses on the
decision-making role of the financial manager. Finance personnel
meet with other officers of the firm and participate in making
decisions affecting the current and future utilization of the firm’s
resources. As an example, managers may discuss the total amount
of assets needed by the firm to carry out its operations. They will
determine the composition or a mix of assets that will help the
firm best achieve its goals. They will identify ways to use existing
assets more effectively and reduce waste and unwarranted expenses.
The decision-making role crosses liquidity and profitability lines.
Converting the idle equipment into cash improves liquidity. Reducing
costs improves profitability.
9. Managing Funds: In the management of funds, the financial manager
acts as a specialised staff officer to the Chief Executive of the company.
The manager is responsible for having sufficient funds for the firm
to conduct its business and to pay its bills. Money must be located to
finance receivables and inventories, 10 make arrangements for the
purchase of assets, and to identify the sources of long-term financing.
Cash must be available to pay dividends declared by the board of
directors. The management of funds has therefore, both liquidity and
profitability aspects.

34
Financial Management as Science or Art
Financial management is both a science and an art. Its nature
is nearer to applied sciences as it envisages use of classified and tested
knowledge as a help in practical affairs and solving business.
Theory of financial management is based on certain systematic
principles, some of which can be tested in mathematical equations like
the law of physics and chemistry. Financial management contains a much
larger body of rules or tendencies that hold true in general and on the
average. The use of computers, operations research, statistical techniques
and econometric models find wide application in financial management
as tools for solving corporate financial problems like budgeting, choice
of investments, acquisition or mergers etc. This takes the financial
management nearer to treatment as a subject of science.
Most practical problems of finance have no hard and fast answers
that can be worked out mathematically or programmed on a computer.
They must be solved by judgment, intuition and the “feel” of experience.
Thus, despite its frequent acceptance as an applied science, finance
remains largely an art. Because, according to George A. Christy and
Feyton Foster Roden (Finance: Environment and Decisions) knowledge
of facts, principles and concepts is necessary for making decisions but
personal involvement of the manager through his intuitive capacities
and power of judgment becomes essential. As the application of human
judgement and skills is also required for effective financial management,
financial management is also an art.

In the entire study of financial management whether it is
related to investment decisions, financing decisions i.e. deciding about
the sources of financing, or dividend decisions, there is a mixture of
science as well as art. When techniques for analytical purposes are
used, it is science and when choice is application of the results it is an
art.
Summary
Financial management is the application of planning and control to
the finance function. It helps in profit planning, measuring costs,
and controlling inventories and accounts receivables. It also helps in
monitoring the effective deployment of funds in fixed assets and in

35
working capital. It aims at ensuring that adequate cash is on hand to
meet the required current and capital expenditure. It facilitates ensuring
that significant capital is procured at the minimum cost to maintain
adequate cash on hand to meet any exigencies that may arise in the
course of business. Financial management is applicable to every type of
organization, irrespective of the size, kind or nature. Every organization
aims to utilize its resources in a best possible and profitable way. Financial
management essentially involves risk-return trade-off. Decisions on
investment involve choosing of types of assets which generate returns
accompanied by risks. Generally higher the risk returns might be higher
and vice versa. So, the financial manager has to decide the level of risk
the firm can assume and satisfy with the accompanying return. Financial
management affects the survival, growth and vitality of the institution.
Financial management is related to other disciplines like accounting,
economics, taxation, operations research, mathematics, statistics etc., It
draws heavily from these disciplines. Financial management is both a
science and an art. Its nature is nearer to applied sciences as it envisages
use of classified and tested knowledge as a help in practical affairs and
solving business. In the entire study of financial management whether it
is related to investment decisions, financing decisions i.e. deciding about
the sources of financing, or dividend decisions, there is a mixture of
science as well as art. When techniques for analytical purposes are used,
it is science and when choice is application of the results it is an art.
Keywords
Financial Management:
Financial management is the application of planning and control
to the finance function. It helps in profit planning, measuring costs, and
controlling inventories, accounts receivables.
Planning:
Determining future course of action.
Art of Management:
Application of science in the attainment of practical results.
Science of Management:
A body of knowledge consisting of concepts, principles and
techniques organized around managerial functions.

36
Review Questions
1) What is financial management?
2) Define financial management. Explain its significance.
3) Explain the various areas of financial management.
4) Analyse the nature of financial management.
5) Describe the evolution of financial management.
6) Financial management – is it a science or an art.
7) What are key areas of financial management?
8) Explain the role of financial manager in the current scenario.
****

37
Lesson 4 - Financial Goals
Lesson Outline
ӹӹ Objectives / goals – Meaning
ӹӹ Significance goals of Financial Management
ӹӹ Goals of Financial Management
ӹӹ Profit Maximisation
ӹӹ Arguments in favour of Profit Maximisation
ӹӹ Criticisms leveled against Profit Maximisation
ӹӹ Wealth maximisation
ӹӹ Profit maximization Vs Wealth Maximisation
Learning Objectives
ӹӹ Understand the meaning of objectives / goals
ӹӹ Know the significance of financial goals
ӹӹ Spell out the different goals of financial management
ӹӹ To understand the significance of profit maximization
ӹӹ Put-forth arguments in favour of profit maximization
ӹӹ Point out criticisms
ӹӹ Understand the significance of wealth maximization
ӹӹ Distinguish between PM & WM
Objectives / Goals – Meaning
Objectives or goals are the end results towards which activities
are aimed. Formulation and definition of objectives of an organization
is the basic requirement of effective management. According to George
R. Terry, “a managerial objective is the intended goal which prescribes
definite safe and suggests direction to efforts of a manager”. Further
objectives can either he short term or long-term. As business activities
involve allocation of source resources among alternative uses, expected

38
return must be balanced against its opportunity cost. It is a fait accompli
to observe firms wishing to pursue several goals, of which profit
maximization is of primary objective. Every firm or an organization wish
to maximize profits, while at the same time minimizes expenses.
Significance
Financeguidesandregulatesinvestmentdecisionsandexpenditure
of administers economic activities. The scope of finance is vast and
determined by the financial requirements of the business organization.
The objective provides a frame work for optimum financial decision
– making. In other words, to ensure optimum decisions the goals of
financial management must be made clearer. The financial management
functions covers decision making in three inter-related areas, namely
investment, financing and dividend policy. The financial manager has to
take these decisions with reference to the objectives of the firm. Financial
management provides a framework for selecting a proper course of
action and deciding a viable commercial strategy. The main objective
of a business is to maximize the owners’ economic welfare. The goals
of financial management of a corporate enterprise succinctly brought
out by Alfred Rappaport which is reproduced below: “In a market based
economy which recognize the rights of private property, the only social
responsibility of business is to create value and do so legally and with
integrity. It is a profound error to view increases in a company’s value
as a concern just for its shareholders. Enlightened managers and public
officials’ recognizer that increase in stock priced reflect improvement in
competitiveness – an issue which affects everyone who has a stake in the
company or economy”.
Goals of Financial Management
Goals act as motivators, serve as the standards for measuring
performance, help in coordination of multiplicity of tasks, facilitate in
identifying inter departmental relationships and so on. The goals can be
classified as official goals, operative goals and operational goals.
The official goals are the general objective of any organization. They
include mechanism of ROI and market value of the firms.
The operative goals indicate the actual efforts taken by an organization
to implement various plans, policies and norms.

39
The operational goals are more directed, quantitative and verifiable. In
fine, it can be inferred that the official, operative and operational goals
are set with a pyramidal shape, the official goals at the helm of affairs
(concerned with top level executives) operative goals at the middle level
and operational goals at the lower level.
Following are the other objectives of financial management.
a) To build up reserves for growth and expansion
b) To ensure a fair return to shareholders
c) To ensure maximum operational efficiency by efficient and
effective utilization of finances.
The financial decisions can rationally be made only when the
business enterprise has certain well thought out objectives. It is argued
that the achievement of central goal of maximisation of the owner’s
economic welfare depends upon the adoption of two criteria, viz., i)
profit maximisation; and (ii) wealth maximisation.
Profit Maximisation
The term ‘profit maximization’ implies generation of largest
amount of profits over the time period being analysed, secondary to Prof.
Peter Drucker, business profits play a functional role in three different
ways. In the words of Peter Drucker
ӹӹ Profits indicate the effectiveness of business profits
ӹӹ They provide the premium to cover costs of staying in business
and
ӹӹ They ensure supply of future capital.
Profits are source of funds from which organizations are able to
defray certain expenses like replacement, obsolescence, marketing etc.
Maximization of profits for a long term is desirable and
appreciable. The tendency to maximize profits in the short run may
invite innumerable problems to the organization concerned. In fact,
maximization of profits in the short run may give an impression of
being exploitative. The extent of uncertainty in business increases the
appreciation of proprietor / partner / company and hence many prefer

40
short-run profit maximisation to long –run profit maximisaiton.
The underlying basic of profit maximization is efficiency. It is
assumed that profit maximization causes the efficient allocation of
resources under the competitive impact conditions and profit is regarded
as the most appropriate measure of a firm’s performance.
Arguments in favour of profit maximization
Arguments in favour of profit maximization as the objective of
business are enumerated below:
1. Profits are the major source of finance for the growth and
development of its business.
2. Profitability serves as a barometer for measuring efficiency and
economic prosperity of a business entity.
3. Profits are required to promote socio-economic welfare.
Criticisms levelled against profit maximization
However, profit maximization objective has been criticized on
innumerable grounds. Under the changed economic and corporate
environment, profit-maximisation is regarded as unrealistic, difficult,
unappropriate and socially not much liked goal for business organizations.
Profit maximization as an objective of financial management has been
considered inadequate and rejected because of the following drawbacks.
1) There are several goals towards which a business firm /
organization should direct themselves profit – maximization is
one of the goals of the organization and not the only goal.
2) Maintenance of firm’s share in the market, development and
growth of the firm, expansion and diversification are other goals
of business concern.
3) Rendering social responsibility
4) Enhancing the shareholders’ wealth maximization.
As Solomon opines, profit maximisation has been rejected as an
operational criterion for maximising the owner’s economic welfare as it
cannot help us in ranking alternative courses of action in terms of their
economic efficiency. This is because—(i) it is vague; (ii) it ignores the
timing of returns; (iii) it ignores risk.
Profit maximisation is considered as an important goal in

41
financial decision-making in an organisation. It ensures that firm utilizes
its available resources most efficiently under conditions of competitive
markets. Profit maximisation as corporate goal is criticised by scholars
mainly on following grounds:
i. It is vague conceptually.
ii. It ignores timing of returns.
iii. It ignores the risk factor.
iv. It may tempt to make such decisions which may in the long run
prove disastrous.
v. Its emphasis is generally on short run projects.
vi. It may cause decreasing share prices.
vii. The profit is only one of the many objectives and variables that
a firm considers.
Wealth Maximisation
Wealth Maximisation refers to all the efforts put in for maximizing
the net present value (i.e. wealth) of any particular course of action which
is just the difference between the gross present value of its benefits and
the amount of investment required to achieve such benefits.
Wealth maximisation principle is also consistent with the objective
of ‘maximising the economic welfare of the proprietors of the firm’. This,
in turn, calls for an all out bid to maximise the market value of shares of
that firm which are held by its owners. As Van Horne aptly remarks, the
market price of the shares of a company (firm) serves as a performance
index or report card of its progress. It indicates how well management is
doing on behalf of its share-holders.
The wealth maximization objective serves the interests of suppliers
of loaned capital, employees, management and society. This objective not
only serves shareholders interests by increasing the value of holding but
also ensures security to lenders also. According to wealth maximization
objective, the primary objective of any business is to maximize share
holders wealth. It implies that maximizing the net present value of a
course of action to shareholders.
According to Solomon, net, present – value or wealth of a course
of action is the difference between the present value of its benefits and
the present value of its costs. The objective of wealth maximization is

42
an appropriate and operationally feasible criteria to chose among the
alternative financial actions. It provides an unambiguous measure
of what financial management should seek to maximize in making
investment and financing decisions on behalf of shareholders. However,
while pursuing the objective of wealth maximization, all efforts must
be employed for maximizing the current present value of any particular
course of action. It implies that every financial decision should be based
on cost – benefit analysis. The shareholders, who obtained great benefits,
would not like a change in the management. The share’s market price
serves as a performance index. It also reflects the efficiency and efficacy
of the management.
The Necessity of a Valuation Model portend has shown how the
attainment of the objective of maximising the market value of the firm’s
shares (i.e. wealth maximisation) requires an appropriate Valuation model
to assess the value of the shares of the firm in Question. The Financial
Manager should realise or at least assume the extent of influence various
factors are capable of wielding upon the market price of his company’s
shares. If not he may, not be able to maximise the value of such shares.

Financial management is concerned with mobilization of
financial resources and their effective utilization towards achieving
the organization its goals. Its main objective is to use funds in such a
way that the earnings are maximized. Financial management provides a
framework for selecting a proper course of action and deciding a viable
commercial strategy. A business firm has a number of objectives. Peter
Driven has outlined the possible objectives of a firm as follows.
ӹӹ Market standing
ӹӹ Innovation
ӹӹ Productivity
ӹӹ Economical use of physical and financial resources
ӹӹ Increasing the profitability
ӹӹ Improved performance
ӹӹ Development of worker’s performance and co-operatives
ӹӹ Public responsibility

43
The wealth maximizing criterion is based on the concept of cash
flows generated by the decision rather than according profit which is the
basis of the measurement of benefits in the case of profit maximization
criterion. Measuring benefits in terms of cash flows avoids the ambiguity
associated with accounting profits.
Presently, maximisation of present value (or wealth) of a course of
action is considered appropriate operationally flexible goal for financial
decision-making in an organisation. The net present value or wealth can
be defined more explicitly in the following way:
A1
A2
A3
An
∑At
W = -----------+----------+ ----------+ …....+----------- Co = -----------
-- Co
(1 + K1
) (1 + K1
) (1 + K1
) (1 + K1
) ∑(1 + K) t
Where A1
and A2
represent the stream of benefits expected to
occur if a course of action is adopted. Co is the cost of that action and
K is the appropriate discount rate, and W is the Net present worth or
wealth which is the difference between the present worth or wealth of
the stream of benefits and the initial cost.
The management of an organisation maximises the present value
not only for shareholders but for all including employees, customers,
suppliers and community at large. This goal for the maximum present
value is generally justified on the following grounds:
i. It is consistent with the object of maximising owners’ economic
welfare.
ii. It focuses on the long run picture.
iii. It considers risk.
iv. It recognises the value of regular dividend payments.
v. It takes into account time value of money.
vi. It maintains market price of its shares
vii. It seeks growth is sales and earnings.
Maximizing the shareholders’ economic welfare is equivalent
to maximizing the utility of their consumption every time. With their
wealth maximized, shareholders can afford their cash flows in such a way

44
as to optimize their consumption. From the shareholders point of view,
the wealth created by a company through the actions is reflected in the
market value of the company’s shares.
Profit Maximisation versus Shareholder Wealth Maximization
Profit maximization is basically a single-period or, at the most,
a short-term goal. It is usually interpreted to mean the maximization of
profits within a given period of time. A firm may maximize its short-term
profits at the expense of its long-term profitability and still realize this
goal. In contrast, shareholder wealth maximization is a long-term goal
shareholders are interested in future as well as present profits. Wealth
maximization is generally preferred because it considers (1) wealth for
the long term, (2) risk or uncertainty. (3) the timing of returns, and (4)
the “shareholders’ return. The following table provides a summary of the
advantages and disadvantages of these two often conflicting goals
Table 1.1 – Profit Maximisation Versus Shareholder Wealth
Maximization
Goal Objective Advantages Disadvantages
Profit
Maximisation
Large amount
of profits
1. Easy to
calculate profits
2. Easy to
determine the
link between
financial
decisions and
profits
1. Emphasizes the
short-term
2. Ignores risk or
uncertainty
3. Ignores the
timing of returns
4. Requires
immediate
resources

45
Shareholder
wealth
maximization
Highest
market value
of common
stock
1. Emphasizes
the long term
2. Recognises
risk or
uncertainty
3. Recognises the
timing of returns
4. Considers’
return
1. Offers no
clear relationship
between financial
decisions and
stock price.
2. Can lead to
management
anxiety and
frustration
Summary
Objectives or goals are the end results towards which activities
are aimed. Formulation and definition of objectives of an organization
is the basic requirement of effective management. Finance guides and
regulates investment decisions and expenditure of administers economic
activities. The scope of finance is vast and determined by the financial
requirements of the business organization. The objective provides a
frame work for optimum financial decision – making. In other words,
to ensure optimum decisions the goals of financial management must
be made clearer. The financial management functions covers decision
making in three inter-related areas, namely investment, financing and
dividend policy. The financial manager has to take these decisions
with reference to the objectives of the firm. The financial decisions can
rationally be made only when the business enterprise has certain well
thought out objectives. It is argued that the achievement of central goal of
maximisation of the owner’s economic welfare depends upon the adoption
of two criteria, viz., i) profit maximisation; and (ii) wealth maximisation.
The term ‘profit maximization’ implies generation of largest amount of
profits over the time period. Wealth Maximisation refers to all the efforts
put in for maximizing the net present value (i.e. wealth) of any particular
course of action which is just the difference between the gross present
value of its benefits and the amount of investment required to achieve
such benefits. The other objectives of financial management include a)
building up reserves for growth and expansion, b) To ensure a fair return
to shareholders and c) To ensure maximum operational efficiency by
efficient and effective utilization of finances.

46
Key words
Optimal Decisions:
The decision which relate to physical inputs, outputs and other
variables (i.e. non-financial variables).
Profit Maximisation :
The term ‘profit maximization’ implies generation of largest
amount of profits over the time period.
Wealth Maximisation :
It refers to all the efforts put in for maximizing the net present
value (i.e. wealth) of any particular course of action which is just the
difference between the gross present value of its benefits and the amount
of investment required to achieve such benefits.
Review Questions
1) Explain the objectives or goals of financial management.
2) Explaintheconceptofwealthinthecontextofwealthmaximization
objective.
3) “The wealth maximization objective provides an operationally
appropriate decision criterion” – Analyse the statement.
4) In what respect is the objective of wealth maximization superior
to the profit maximization objective?
5) Give the arguments for profit maximization as an objective of a
firm.
6) What are the arguments levelled against profit maximization
objective?
7) What are the other objectives of financial management?
****

47
Lesson 5 - Financial Decisions
Lesson Outline
ӹӹ Introduction
ӹӹ Financial decision – types
ӹӹ Investment decisions
ӹӹ Financing decision
ӹӹ Dividend decision
ӹӹ Liquidity
ӹӹ Relationship of financial Decisions
ӹӹ Factors influencing Financial decisions
Learning Objectives
ӹӹ To understand the various types of financial decisions
ӹӹ To describe the relationship of financial decisions
ӹӹ To identify the various factors influencing financial decisions.
Introduction
Finance comprises of blend of knowledge of credit, securities,
financial related legislations, financial instruments, financial markets
and financial system. As finance is a scarce resource, it must be
systematically raised form the cheapest source of funds and must be
judiciously utilized for the development and growth of the organization.
Charles Gertenberg visualizes the significance of scientific arrangement
of records with the help of which the inflow and outflow of funds can be
efficiently managed, stocks and bonds can be efficiently marketed and
the efficacy of the organization can be greatly improved.

48
The financial manager in his new role, is concerned with the
efficient allocation of funds. The firm’s investment and financing decisions
are continuous. The financial manager according to Ezra Solomon must
find a rationale for answering the following three questions.
1) How large should an enterprise be and how fast should it grow?
2) In what form should it hold its assets?
3) How should the funds required be raised?
It is therefore clear from the above discussion that firms take different
financial decisions continuously in the normal course of business.
Liquidity, solvency, profitability and flexibility optimization goals and
risk, would lead to reaping of wealth maximization goal.
Financial Decisions – Types
Financial decisions refer to decisions concerning financial matters
of a business firm. There are many kinds of financial management
decisions that the firm makers in pursuit of maximising shareholder’s
wealth, viz., kind of assets to be acquired, pattern of capitalisation,
distribution of firm’s income etc. We can classify these decisions into
three major groups:
1. Investment decisions
2. Financing decision.
3. Dividend decisions.
4. Liquidity decisions.
1. Investment Decisions / Capital Budgeting Decisions
Investment Decision relates to the determination of total amount
of assets to be held in the firm, the composition of these assets and the
business risk complexities of the firm as perceived by the investors. It is
the most important financial decision. Since funds involve cost and are
available in a limited quantity, its proper utilization is very necessary to
achieve the goal of wealth maximasation.
The investment decisions can be classified under two broad
groups; (i) long-term investment decision and (ii) Short-term, in

49
vestment decision. The long-term investment decision is referred to as
the capital budgeting and the short-term investment decision as working
capital management.
Capital budgeting is the process of making investment decisions
in capital expenditure. These are expenditures, the benefits of which are
expected to be received over a long period of time exceeding one year. The
finance manager has to assess the profitability of various projects before
committing the funds. The investment proposals should be evaluated in
terms of expected profitability, costs involved and the risks associated
with the projects. The investment decision is important not only for
the setting up of new units but also for the expansion of present units,
replacement of permanent assets, research and development project
costs, and reallocation of funds, in case, investments made earlier, do
not fetch result as anticipated earlier.
2. Financing Decisions / Capital Structure Decisions
Once the firm has taken the investment decision and committed
itself to new investment, it must decide the best means of financing
these commitments. Since, firms regularly make new investments; the
needs for financing and financial decisions are on going, hence, a firm
will be continuously planning for new financial needs. The financing
decision is not only concerned with how best to finance new asset, but
also concerned with the best overall mix of financing for the firm.
A finance manager has to select such sources of funds which will
make optimum capital structure. The important thing to be decided
here is the proportion of various sources in the overall capital mix of the
firm. The debt-equity ratio should be fixed in such a way that it helps in
maximising the profitability of the concern. The raising of more debts
will involve fixed interest liability and dependence upon outsiders. It
may help in increasing the return on equity but will also enhance the risk.
The raising of funds through equity will bring permanent funds to the
business but the shareholders will expect higher rates of earnings. The
financial manager has to strike a balance between anxious sources so that
the overall profitability of the concern improves. If the capital structure
is able to minimise the risk and raise the profitability then the market
prices of the shares will go up maximising the wealth of shareholders.

50
3. Dividend Decision
The third major financial decision relates to the disbursement
of profits back to investors who supplied capital to the firm. The term
dividend refers to that part of profits of a company which is distributed by
it among its shareholders. It is the reward of shareholders for investments
made by them in the share capital of the company. The dividend decision
is concerned with the quantum of profits to be distributed among
shareholders. A decision has to be taken whether ail the profits are to be
distributed, to retain all the profits in business or to keep a part of profits
in the business and distribute others among shareholders. The higher
rate of dividend may raise the market price of shares and thus, maximise
the wealth of shareholders. The firm should also consider the question
of dividend stability, stock dividend (bonus shares) and cash dividend.
4. Liquidity Decisions
Liquidity and profitability are closely related. Obviously,
liquidity and profitability goals conflict in most of the decisions. The
finance manager always perceives / faces the task of balancing liquidity
and profitability. The term liquidity implies the ability of the firm to
meet bills and the firm’s cash reserves to meet emergencies whereas
profitability aims to achieve the goal of higher returns. As said earlier,
striking a proper balance between liquidity and profitability is a difficult
task. Profitability will be affected when all the bills are to be settled in
advance. Similarly, liquidity will be affected if the funds are invested in
short term or long term securities. That is the funds are inadequate to
pay-off its creditors. Lack of liquidity in extreme situations can lead to
the firm’s insolvency.
Risk – Return Trade Off
Further where the company is desirous of mobilizing funds from
outsidesources,itisrequiredtopayinterestatfixedperiod.Henceliquidity
is reduced. A successful finance manager has to ensure acceleration of
cash receipts (cash inflows in to business) and deceleration of cash (cash
outflows) from the firm. Thus forecasting cash flows and managing
cash flows are one of the important functions a finance manager that
will lead to liquidity. The finance manager is required to enhance his
professionalism and intelligence to ensure that return is optimized.

51
Return = Risk-free rate + Risk premium
Risk free rate is a compensation for time and risk premium for
risk. Higher the risk of an action, higher will be the risk premium leading
to higher required return on that action. This levelling of return and
risk is known as risk return trade off. At this level, the market value of
the company’s shares should be the maximum. The diagram given below
spells out the interrelationship between market value, financial decisions
and risk-return trade off.
Interrelationship between market value, financial decisions and risk-
return trade off
Finance
Manager
Maximization of
Share Value
Financial
Decision
Funds
requirement
decision
Financing
Decision
Investment
decision
Dividend
decision
Return Risk
Trade off
Value of Firm – Risk Return
The finance manager tries to achieve the proper balance between,
the basic considerations of ‘risk and return’ associated with various
financial management decisions to maximise the market, value, of the
firm.
It is well known that “higher the return other things being equal,
higher the market value; higher the risk, other things being equal, lower

52
the market value’. In fact, risk and return go together. It is quite evident
from the aforesaid discussion that financial decisions have a great impact
on all other business activities. The modern finance manager has to
facilitate making these decisions in the most rational way. The decisions
have to be made in such a way that the funds of the firms / organizations
are used optimally. The financial reporting system must be designed to
provide timely and accurate picture of the firm’s activities.
Relationship of Financial Decisions
The financial manager is concerned with the optimum utilization
of funds and their procurement in a manner that the risk, cost and
control considerations are properly balanced in a given situation.
Irrespective of nature of decisions, i.e. investment decisions, financing
or capital structure decisions / dividend decisions all these decisions are
interdependent. All these decisions are inter-related. All are intended to
maximize the wealth of the shareholders. An efficient financial manager
has to ensure optimal decision by evaluating each of the decision involved
in relation to its effect on shareholders wealth.
Factors Influencing Financial Decisions
There are innumerable factors that influence the financial
decision. They are classified as external factors and internal factors.
External factors
 Capital structure
 Capital market and money market
 State of economy
 Requirements of investors
 Government policy
 Taxation policy
 Financial institutions / banks lending policy
Internal factors
 Nature of business
 Age of the firm
 Size of the business
 Extent and trend of earnings
 Liquidity position

53
 Working capital requirements
 Composition of assets
 Nature of risk and expected return
Summary
Finance comprises of blend of knowledge of credit, securities,
financial related legislations, financial instruments, financial markets and
financial system. As finance is a scarce resource, it must be systematically
raised form the cheapest source of funds and must be judiciously utilized
for the development and growth of the organization. Financial decisions
refer to decisions concerning financial matters of a business firm. There
are many kinds of financial management decisions that the firm makers
in pursuit of maximising shareholder’s wealth, viz., kind of assets to be
acquired, pattern of capitalisation, distribution of firm’s income etc.
We can classify these decisions into three major groups: 1) Investment
decisions, 2) Financing decision, 3) Dividend decisions, and 4) Liquidity
decisions.
Investment Decision relates to the determination of total
amount of assets to be held in the firm, the composition of these assets and
the business risk complexities of the firm as perceived by the investors.
The financing decision is not only concerned with how best to finance
new asset, but also concerned with the best overall mix of financing for
the firm. A finance manager has to select such sources of funds which
will make optimum capital structure. The dividend decision is concerned
with the quantum of profits to be distributed among shareholders. A
decision has to be taken whether ail the profits are to be distributed,
to retain all the profits in business or to keep a part of profits in the
business and distribute others among shareholders. The higher rate of
dividend may raise the market price of shares and thus, maximise the
wealth of shareholders. The term liquidity implies the ability of the firm
to meet bills and the firm’s cash reserves to meet emergencies whereas,
the profitability means the ability of the firm to obtain highest returns
within the funds available. As said earlier, striking a proper balance
between liquidity and profitability is a difficult task. The finance manager
tries to achieve the proper balance between, the basic considerations of
‘risk and return’ associated with various financial management decisions
to maximise the market, value, of the firm. The financial manager is
concerned with the optimum utilization of funds and their procurement

54
in a manner that the risk, cost and control considerations are properly
balanced in a given situation
Keywords
Financial decisions:
It refers to decisions concerning financial matters of a business
firm.
Risk Free Rate:
It is a compensation for time and risk premium for risk.
Risk – Return Trade Off:
Levelling of risk and return is known as risk – return trade off.
Review Questions
1) What is meant by financial decision?
2) Explain investment decision.
3) Explain liquidity Vs. Profitability?
4) Discuss the significance of various financial decisions.
5) What is meant by liquidity decision?
6) Explain risk-return trade off.
****

55
UNIT – II
Lesson 1 - Capital Budgeting – A Conceptual Framework
Lesson Outline
ӹӹ Meaning of Capital Budgeting
ӹӹ Capital expenditure
ӹӹ Definition
ӹӹ Need for capital investment
ӹӹ Capital budgeting-significance
ӹӹ Capital Budgeting process
ӹӹ Factors influencing Investment decisions
ӹӹ Kinds of Capital Budgeting Decisions
Learning Objectives
After reading this lesson you should be able to
ӹӹ Understand the meaning of Capital budgeting
ӹӹ Know about capital expenditure
ӹӹ Understand the need for capital investment
ӹӹ Point out the significance of capital budgeting
ӹӹ Describe the capital budgeting process
ӹӹ Spell out the factors influencing investment decisions
ӹӹ Describe the kinds of capital budgeting decisions
Capital budgeting decisions are of paramount importance in
financial decisions, because efficient allocation of capital resources is one
of the most crucial decisions of financial management. Capital budgeting

56
is budgeting for capital projects. It is significant because it deals with
right kind of evaluation of projects. The exercise involves ascertaining
/ estimating cash inflows and outflows, matching the cash inflows with
the outflows appropriately and evaluation of desirability of the project.
It is a managerial technique of meeting capital expenditure with the
overall objectives of the firm. Capital budgeting means planning for
capital assets. It is a complex process as it involves decisions relating to
the investment of current funds for the benefit to be achieved in future.
The overall objective of capital budgeting is to maximize the profitability
of the firm / the return on investment.
Capital Expenditure
A capital expenditure is an expenditure incurred for acquiring
or improving the fixed assets, the benefits of which are expected to be
received over a number of years in future. The following are some of the
examples of capital expenditure.
1. Cost of acquisition of permanent assets such as land & buildings,
plant & machinery, goodwill etc.
2. Cost of addition, expansion, improvement or alteration in the
fixed assets.
3. Cost of replacement of permanent assets.
4. Research and development project cost etc.
5. Capital expenditure involves non-flexible long term commitment
of funds.
Capital Budgeting – Definition
“Capital budgeting” has been formally defined as follows.
1) “Capital budgeting is long-term planning for making and
financing proposed capital outlay”.
- Charles T. Horngreen
2) “The capital budgeting generally refers to acquiring inputs with
long-term returns”.
- Richards & Greenlaw

57
3) “Capital budgeting involves the planning of expenditure for assets,
the returns from which will be realized in future time periods”.
- Milton H. Spencer
The long-term activities are those activities that influence firms
operation beyond the one year period. The basic features of capital
budgeting decisions are:
ӹӹ There is an investment in long term activities
ӹӹ Current funds are exchanged for future benefits
ӹӹ The future benefits will be available to the firm over series of
years.
Need For Capital Investment
The factors that give rise to the need for capital investments are:
ӹӹ Expansion
ӹӹ Diversification
ӹӹ Obsolescence
ӹӹ Wear and tear of old equipment
ӹӹ Productivity improvement
ӹӹ Learning – curve effect
ӹӹ Product improvement
ӹӹ Replacement and modernization
The firm’s value will increase in investments that are profitable.
They add to the shareholders’ wealth. The investment will add to the
shareholders’ wealth if it yields benefits, in excess of the minimum
benefits as per the opportunity cost of capital.
It is clear from the above discussion what capital investment
proposals involve
a) Longer gestation period
b) Substantial capital outlay
c) Technological considerations
d) Irreversible decisions
e) Environmental issues

Financial management notes pdf

Financial management notes pdf

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Similar to Financial management notes pdf

Similar to Financial management notes pdf (20)

Recently uploaded

Recently uploaded (20)

Financial management notes pdf